Efficient Markets & Market Failure • Market failures are departures from economists’ notion of a perfectly efficient market • In an efficient market firms produce at the lowest possible cost, in terms of resources used, and consumers buy the products they want at the minimum possible price for a given quality
What are the sources of market failure? • Information asymmetries • Externalities • Market power
Asymmetric information • One party to a transaction lacks “relevant” information. • Why? Information is generally too costly to obtain or too complex. • This “relevant” information could/would change the behaviour of this party.
Example – Second hand cars • Can you tell a good car from a bad one? • Imagine you have perfect information – if your valuation of a car is greater than sellers then trade takes place – only good cars may sell • An efficient outcome: All opportunities for trade exploited, both buyer and seller benefit from trade
Second hand cars II • Now imagine there is asymmetric information: you know half are bad but you don’t know which half • Theory says you are willing to pay your average valuation less than informed valuation of good cars • This may not be enough for sellers of good cars they drop out, leaving only “lemons” • Opportunity for trade which would be good for everyone is lost, and market may collapse completely
Second hand cars - What is the problem? • Hidden information (or adverse selection) at point of sale leads to inefficiently small market or no market at all – Informed party can exploit its advantage – Price may not reflect the underlying value of the product – Buyer may not buy what he/she wants
Example • Financial Services – Credit applications – Share/bond offerings • Market Response – Seller can offer a warranty? – Reputation from repeated interaction? – Buyer can pay for some expert advice? • Regulatory Response – Force sellers to provide some information? – Independent certification, e.g. authorisation
Example: Credit market II • Bank cannot observe borrower behaviour after loan is concluded • Here the problem is the hidden action after the contract is signed (moral hazard) • Risk for bank: – excessive risk-taking by borrower
Example: Credit market II • Potential solutions? – collateral – covenant – monitoring – repeated interaction
Example: Payment Protection Insurance • Product is complex (number of exclusions, these are not (made) clear to consumers • In most cases PPI is a secondary product bought in conjunction with a loan, consumers rarely shop around • Little consumer engagement with product
Example: Payment Protection Insurance • Potential market failure • Information gap about: – Suitability of the product for consumers (Do they need it?, Can they claim?) – Price of the product
Example: Payment Protection Insurance • Market Response? • Regulatory Response? – Disclosure requirements (Price, Exclusions)? – Consumer education?
Asymmetric Info: Wholesale vs. Retail • In general, information problems are worse in retail markets: – It is costly for consumers to acquire information and/or relevant skills – Financial contracts are complex – Quality of the product mostly revealed after purchase or not at all (credence goods) – The pyramid scheme problem in Albania Wholesale market participants are more likely to have the resources and incentives to reduce the information gap. • ……or are they?????
Case study: Commodity derivatives review
What is the Commodities Review? • As mandated under MiFID and recast CAD, the Commission is reviewing the regulation of commodity derivatives • Two main issues – Scope of the regulation – Prudential regulation
Why the Review? MiFID • Single EU Market in financial services • Coupled with investor protection regime • Extended the ISD definition of financial instruments to include commodity derivatives Generally, if MIFID applies → CRD applies
Why the Review? • But specialist commodity firms argued that their business and risks were different • Exemptions from MiFID and CRD • Conditional on the Review
Is an exemption from MiFID appropriate? • One of the main objectives of MiFID: retail consumer protection • Questions: - Is commodities business different from other (retail) investment products, i.e. is MiFID protection needed? - In other words: Is asymmetric information an issue?
Is an exemption from MiFID appropriate? (II) • There is very little evidence of direct retail investment in the UK commodity derivatives market • On the wholesale side market failures due to information asymmetries between market participants in commodity derivative markets are limited.
Externalities • Production of a good/service affects parties other than original producers or consumers • These effects are not reflected in market prices • Impact can be negative or positive
Negative Externalities • Impose a cost to others which is not considered in the behaviour of the party that generates the cost too much “damage” is produced
Example: Prudential regulation • Depositors can withdraw (part of) their deposits on demand. • Panic results in widespread withdrawal of deposits • Banks are forced to sell assets (potentially illiquid) even at a loss Externality: depositors do not consider the effect of their withdrawals on the value of the bank (and potentially on the whole financial sector).
Example: Prudential regulation • Banks make their investment choices and set levels of capital without considering the potential domino effect of their failure on other banks. Would they set adequate levels of capital?
Example: Prudential Regulation • Market response? – Industry insurance pools? – Insured deposit consortium? • Regulatory response? – Lender of last resort – Deposit insurance / Compensation scheme – Capital requirements – Supervision
Undesired effects of regulation: Compensation scheme for depositors • Members (banks) share losses to depositors arising from a bankrupt member. • Side effects: – Consumers may stop exercising due care. – As a result, a reduced market discipline can induce banks to engage in even riskier projects (i.e. moral hazard).
How can we minimise these side effects? • Compensation cap? • Minimum capital requirements? • Direct supervision? • Restrictions on investment activities? • Promote public awareness?
Case study: Commodity derivatives review II
Commodities business and externalities • Commodities business and prudential regulation: Exemption from CRD or not? • Questions: - What is the level of systemic risk from commodities business? - Are there (large) negative externalities?
Commodities business and externalities • Joint HMT/FSA DP Although connections do exist between specialist commodity derivative firms and the wider financial markets, systemic risks generated by these firms appear to be generally lower relative to systemic risks generated by financial firms . • This suggests that the negative externalities traditionally addressed by prudential regulation are less marked for commodity firms than for financial firms. (Joint HMT/FSA DP, p.20)
Positive Externalities • Generate a benefit to others. These benefits are not considered in the behaviour of the party that produces the benefit not enough of the good is produced • Examples in financial markets – financial capability, listing regime
Public Goods • In an efficient market: there is rivalry between the consumption of a product and market participants can be excluded from the consumption of this product. In other words, the market failure “public good” is absent. • Examples of public goods: Air, mp3 exchange? • Why is there market failure with public goods? - private sector producers will not supply public goods because they cannot be sure of making an economic profit; - consumers can take a free ride without having to pay for the good or service.
Public goods • Public good problems are related to externalities (the framework within which the FSA deals with these) • In a non-financial setting this market failure may be important for government – defence, law enforcement, light houses, street lamps
Market power • Market power is exercised when companies can persistently raise prices above the level that would be achieved in a competitive market • FSA has no explicit competition objective, i.e. we’re not a competition regulator • The OFT and Competition Commission are the relevant bodies in the UK • But ….
Market Power - Policy issues • But… as policy makers we still have to be mindful about competition issues (FSA has a legal obligation to consider impacts on competition!) – e.g. do we impose significant costs that create “barriers to entry” or force firms to drop out of the market? • Part of the CBA !
Regulatory failure • Regulatory intervention had higher economic costs / lower benefits than originally expected, e.g. – regulation has unintended impacts – regulation did not solve the market failure – regulation made the market failure worse, • Regulatory failure may exist in addition to market failure
Regulatory failure • Example: Basel II and Solvency II – one reason for introduction was high economic burden of the previous regimes (Basel I / Solvency I) and loopholes which allowed opportunities for arbitrage • Perverse incentives of: - Per Dinosaur bone fragment payment policy in China - Per Rodent carcass payment policy to reduce rodent numbers - NFL Draft implications for teams not making the play offs • Regulatory failure, like market failure, is an economic justification for intervention (this includes deregulation!)
Why do we do MFA? • MFA helps us to determine the economic case for intervention • Is there a relevant market failure? • Can we reasonably expect to be able to improve on the market solution?
Market failure analysis: framework (1) A. What is the relevant economic market? B. What are the material market failures and/or regulatory failures in the relevant market (s) now? C. If no intervention takes place will market failures be corrected in the short term?
Market failure analysis: framework (2) A. What is the relevant economic market affected by the proposals? • Definition: economic market is where buyers and sellers interact • How? – Markets can often be defined by product – If so, identify which of the product markets affected are close substitutes for each other • e.g. unit trusts and investment trusts can be close substitutes but car insurance and mortgages are not • When? At the very beginning of the MFA!
Market failure analysis: framework (3) B. What are the market failures and/or regulatory failures in the relevant market (s) now? • Step 1 Determine which objective is the main motivation for the initiative
Market Failures and objectives Relevant FSA objective Market failure Negative externality, Market confidence market power Information asymmetry, market Consumer protection power Public awareness Positive externality Financial Crime Negative externality
Market failure analysis: framework (4) • How to determine whether the market failure is actually relevant? • Step 2: Identify the market failure in the absence of regulation. How? • Consider: – Nature of the relevant product – Nature of firms and consumers – How firms and consumers would interact – think about the incentives of each player in the absence of regulation!
How to determine whether the market failure is actually relevant? • Step 3: consider whether there is existing regulation that ought in principle deal with the market failure – Map existing regulation to that market failure • Step 4: consider whether the regulation identified in step 2 has created problems of its own – Is regulatory failure a problem? – Economic costs higher/benefits lower than originally expected – E.g. regulation did not solve the market failure, made the market failure worse, regulation has unexpected impacts.
How to determine whether the market failure is actually relevant? • Step 5: is the relevant market/regulatory failure actually material to the objective – This requires collecting evidence about the actual state of the market! – The evidence will help to understand to what extent we are observing a market failure (or not) i.e. is the problem ‘material’ – Evidence-based regulation
Market failure analysis: framework (5) C. If no intervention takes place will the market failures be corrected in the short term • Unlikely if there is a significant market failure BUT the market may change due to: – External factors, e.g. financial scandal in another country, Spitzer’s action against dealing ahead in the US – New technology (the web and information asymmetry) – New entrants and Market Power
Recap • What are the sources of market failure? – Information asymmetries – Externalities – Market Power – Public Goods • Regulatory failure is important to consider
Recap An important point to conclude: • By market failure we DO NOT mean any market imperfection • A market failure is an information asymmetry, externality and/or an abuse of market power where the regulator can reasonably expect to be able to improve on the market solution
Key steps in IA (2): Defining objectives & Identifying options
Defining objectives • An overlooked step in IA • Failing to set clear objectives often leads to ill-designed policy that cannot easily be evaluated • This failure typically stems from inaccurate identification and assessment of the problem followed by poor option identification • So, clear identification of the problem makes it easier to set precise policy objectives
Defining objectives • Which in turn makes it easier to identify the benefits associated with solving the problem and meeting the objectives • And if you have clear objectives then you have clear criteria against which to evaluate the policy intervention • Thinking about objectives can help identify overlaps with other policy areas
Defining objectives • The FSA has 4 statutory objectives [consumer protection; market confidence; financial crime; financial capability] so this is a straightforward step for us • We only have to consider whether issues are (i) related to our objectives and (ii) if they pose a material risk to the objectives • But you may have to do more thinking about objectives
Identifying options • There is no requirement to identify a particular number of options – it will vary from case to case • It is normal to consider the “do nothing” option and to think about alternatives to regulation – Principles-based regulation
Identifying options • It is not good practice to use straw men – only select credible options • Judge their credibility against your objectives • And in relation to if and how they affect the incentives of all affected parties
Cost-Benefit analysis (CBA) framework
Recap of earlier session • The test for regulatory intervention: – There must be both market failure and the prospect that intervention will provide a net benefit • What are the sources of market failure: – Information asymmetries – Externalities – Market Power – Public Goods + Don’t forget: Regulatory Failure
Recap of earlier session MFA Framework: A. What is the relevant economic market? B. What are the material market failures and/or regulatory failures in the relevant market(s) now? – Determine which objective is the main motivation for the initiative – Identify the market failure in the absence of regulation – consider whether there is existing regulation that ought in principle deal with the market failure – consider whether the regulation identified has created problems of its own – is the relevant market/regulatory failure actually material to the objective • If no intervention takes place will market failures be corrected in the short term?
This session covers: – A framework to conduct a high level CBA – Identifying the correct baseline – Six-part impact analysis for assessing costs and benefits – How to quantify benefits – Practical points on estimating costs and benefits
High-level CBA: framework (1) A. What broadly are the regulatory options? B. What are the economic and other costs and benefits of the option, relative to doing nothing? C. What is the plan for further CBA work?
High-level CBA: framework (2) A. What broadly are the regulatory options? • Design of policy options is beyond CBA but … – think about how the policy will act on the relevant market failure – addressing “facts of life” will not produce economic benefits – principles & codes can allow efficient compliance, but need to be designed carefully to avoid uncertainty and opportunistic behaviour • Include ‘do nothing’ and ‘market’ solutions
High-level CBA: framework (3) B. What are the economic and other costs and benefits of the option, relative to doing nothing? • Explain how the options would correct the market failure by changing: firms’ behaviour? consumers’ behaviour? transactions in the market? • Individuals – maximise utility (consumer surplus) • Firms – maximise profits • CBA for principles needs to be based on explicit assumptions about supervisions and enforcement
A few concepts • What are costs? – more than compliance costs! • What are the economic benefits? – the effect from addressing the market failures • What is the baseline? – The world under a set of assumptions about what will happen to the relevant markets in the absence of the intervention considered – In most cases, it is the status quo but... world does not stay still. – Must be meaningful to aid option selection
Baselines Two economists meet on the street. One inquires, "How's your wife?" The other responds, "Relative to what?"
Case: Complaints • The market for retail investment advice suffers from a principal-agent problem • Elements of performance are difficult to observe for consumers (information asymmetry) • Experience or credence goods • Current regulation: allows pursuing complaints with no regard to a time limit • Industry argues the lack of a long-stop provision brings about considerable (and costly) uncertainty for firms
Example: Complaints Task: • Read the attached Market Failure Analysis • Conduct a high-level CBA
Six-part impact analysis: a framework for assessing costs and benefits
Six-part impact analysis 1. direct costs to regulators 2. compliance costs to firms 3. quantity of transactions 4. quality of transactions 5. variety of transactions 6. efficiency of competition Analytical challenge of impact assessment Identify the incremental impact of change relative to the baseline
Direct costs • The value of extra resources required by the regulator in respect of the proposed regulation – incl. enforcement and regulatory activities of exchanges • What are the additional resources that will be required? – designing, monitoring and enforcing regulations – typically: staff, IT, training, etc. – don’t ignore overheads! • Generally relatively small unless: – taking over regulation in anew area (e.g. mortgage business) – or large system changes (e.g. Mandatory Electronic Reporting or Sabre II)
Compliance costs to firms • Measures incremental compliance costs • Firms may adjust their business in many indirect ways in response to regulation • Firms would do many of the things that regulation obliges them to do, even in the absence of regulation • Firms might have to do additional things in the absence of regulation
Compliance costs to firms • How are firms’ practices directly affected? – time used by staff or management – literature / documentation – financial resources – IT systems / data gathering • Separate between effort - e.g. number of hours - and “unit costs” • Unit costs: think of opportunity costs – what is the cost of an extra hour of training? • Practically: surveys, evidence from literature and previous cost gathering exercises, cost of capital estimates etc. • May lead to other market impacts. How?
Compliance costs to firms: example • Compliance costs associated with prudential capital requirements: – one-off cost associated with raising the capital required (e.g. fees for investment bank), – on-going financing cost and the costs of running required stress and scenario tests • In both cases, we should be interested only in costs beyond what is necessary for the purpose of risk control and internal governance.
Quantity of transactions • A cost: if intervention prevents certain transactions that should have taken place – How does regulation affect the costs of bringing a product to the market? – How does it affect the price of the product? – How does price affect consumption?
Recommend
More recommend
